Lecture 5 – Inflation &Unemployment

1. Money. Inflation. Inflation Causes and Consequences.

2. Unemployment and Its Forms.

3. Relationship between Inflation and Unemployment. Okun's Law. The Phillips Curve.

Inflationary Spiral – інфляційна спіраль

Creeping inflation — повзуча (помірна) інфляція

Galloping inflation – галопуюча інфляція

Cost-push inflation – інфляція витрат (пропозиції)

Demand-pull inflation – інфляція попиту

1. Money. Inflation. Its Causes and Consequences

Before considering inflation phenomenon we have to revise money issue for “Inflation is always and everywhere a monetary phenomenon’’ according to Milton Friedman. The quantity theory of money leads us to agree that the growth in the quantity of money is the primary determinant of the inflation rate.

In macroeconomics money is the stock of assets used for transactions. It serves as a store of value, a unit of account, and a medium of exchange. Different sorts of assets are used as money: commodity money systems use an asset with intrinsic value, whereas fiat money systems use an asset whose sole function is to serve as money. In modern economies, a central bank such as the Federal Reserve is responsible for controlling the supply of money.

All the assumptions on monetary policy are made on the basis of the quantity theory of money assumes that the velocity of money is stable and concludes that nominal GDP is proportional to the stock of money (MV PY). Because the factors of production and the production function determine real GDP, the quantity theory implies that the price level is proportional to the quantity of money. Therefore, the rate of growth in the quantity of money determines the inflation rate:

% Change in M + % Change in V = % Change in P + % Change in Y.

Thus, the quantity theory of money states that the central bank, which controls the money supply, has ultimate control over the rate of inflation. If the central bank keeps the money supply stable, the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly.

When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. If the government prints money it has the revenue called seigniorage. Printing money to raise revenue is like imposing an inflation tax. It is a tax on money holding. Although seigniorage is quantitatively small in most economies, it is often a major source of government revenue in economies experiencing hyperinflation.

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy.

A chief measure of price inflation is the inflation rate (π), the annualized percentage change in a general price index (normally the Consumer Price Index) over time.

Other common measures of inflation are:

GDP deflator, Producer price indices, Commodity price indices...

Big Mac Index (was introduced in The Economist in September 1986 by Pam Woodall as an informal way of measuring the purchasing power parity (PPP) between two currencies and provides a test of the extent to which market exchange rates result in goods costing the same in different countries. The Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big Mac in one country (in its currency) by the price of a Big Mac in another country (in its currency). This value is then compared with the actual exchange rate; if it is lower, then the first currency is under-valued (according to PPP theory) compared with the second, and conversely, if it is higher, then the first currency is over-valued).

Purchasing power parity (PPP) is a condition between countries where an amount of money has the same purchasing power in different countries. The concept is based on the law of one price, where in the absence of transaction costs and official trade barriers, identical goods will have the same price in different markets when the prices are expressed in the same currency.

Another interpretation is that the difference in the rate of change in prices at home and abroad - the difference in the inflation rates - is equal to the percentage depreciation or appreciation of the exchange rate.

Nowadays Harmonised Indices of Consumer Prices (HICPs) are designed for international comparisons of consumer price inflation. HICP is used for example by the European Central Bank for monitoring of inflation in the Economic and Monetary Union and for the assessment of inflation convergence. Data on (epp.eurostat.ec.europa.eu)

Types of inflation depending on growth:

Creeping inflation – an inflation at moderate rates but persisting over long periods (less than 10%). This is the normal state of affairs in many countries.

Galloping inflation – the movement of price accelerates rapidly price increases about 10-100% per year.

Hyperinflation – an out-of-control inflationary spiral. Definitions used vary from the IASB´s (The International Accounting Standards Board ) a cumulative inflation rate over three years approaching 100% to academic literature´s "inflation exceeding 50% a month."

Deflation – a fall in the general price level.

Disinflation – a decrease in the rate of inflation.

Stagflation – a combination of inflation, slow economic growth and high unemployment.

There are three major types of inflation:

Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc. More accurately, it should be described as involving "too much money spent chasing too few goods", since only money that is spent on goods and services can cause inflation.

Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs such as wage.

Built-in inflation is induced by adaptive expectations, and is often linked to the "price/wage spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices.